Initiating a cash discount Gardner Company currently makes all sales on credit a
ID: 2788995 • Letter: I
Question
Initiating a cash discountGardner Company currently makes all sales on credit and offers no cash discount. The firm is considering offering a 1% cash discount for payment within 15 days. The firm's current average collection period is 60 days, sales are 40,000 units, selling price is $45 per unit, and variable cost per unit is $33. The firm expects that the change in credit terms will result in an increase in sales to 44,000 units, that 70% of the sales will take the discount, and that the average collection period will fall to 30 days. If the firm's required rate of return on equal-risk investments is 25%, should the proposed discount be offered?
(Note: Assume a 365-day year.)
Explanation / Answer
Additional profit contribution from sales = 4,000 additional units × ($45 $33) = $48,000
Cost of marginal investment in A/R:
Average investment, proposed plan = 44,000 units *$33/365 /30 = $119342.47
Average investment, present plan = 40, 000 units* $33/ 365 /60 = 216986.30
Reduced investment in A/R $97643.83(1)
Required return on investment × 0.25 (2)
Cost of marginal investment in A/R 24410.96
Cost of cash discount = (0.01 × 0.70 × $45 × 44,000 units/2) = -6930
Net profit from implementing proposed plan = 24410.96 - 6930 = 17480.96
Since the net effect would be a profit of $17480.96, the project should be accepted.